WASHINGTON — The government's new program to help small businesses repay their existing debts could end up being both popular and problematic for lenders and borrowers.

The Small Business Administration formally launched the program, America's Recovery Capital, on Monday. The program, which was mandated in the stimulus package, will let lenders make small short-term loans to struggling but "viable" small businesses. Starting June 15, SBA lenders will be able to apply to the agency to lend up to $35,000 to help a small business repay its existing loans.

But given the program's generous terms for borrowers, the money allotted for it likely will run out fast, and lenders could have a hard time defining a "viable" small business. And despite a 100% guarantee, lenders could face reputation risk if many of the loans it makes ultimately fail.

"It's a difficult position to put the lender in," said James Ballentine, the senior vice president for political operations at the American Bankers Association. "Even with the 100% guarantee, the lender is expected to do proper due diligence on the loan, even knowing going in that there's going to be a higher default rate."

The SBA warned in its guidance that, though it expects the program to carry a higher default rate than its normal 7(a) program, a bank's performance would be taken into account in the agency's assessment of its overall performance as a lender.

To avoid such risk, SBA lenders could submit the application for the loan directly to the agency, which would put the onus on the SBA if the borrower defaults.

The program's terms make it especially forgiving for borrowers. To make an Arc loan, a bank will disburse a sum of money over a six-month period, at the end of which the borrower will have a yearlong deferral of repayment on the loan. At the end of the one-year period, the borrower will begin repaying the loan and may take up to five years to complete the repayments, with no interest.

Lenders stand to collect up to six and a half years of interest payments directly from the government, starting at the beginning of the disbursement of the loan. The SBA will pay the lender interest based on the prime rate plus 2 percentage points.

"That's lower than what SBA allows on regular 7(a) loans," said Jane Butler, the executive vice president of the National Association of Government Guaranteed Lenders. "For the purpose of the program," lenders "will probably see it as adequate but not necessarily good."

Borrowers can use the Arc loans to pay off principal on existing business and credit card loans, as long as they are not SBA loans guaranteed before Feb. 17, 2009. The parameters make it likely, lenders said, that banks will want to make Arc loans to their own customers to help them meet their loan obligations.

"We only have a few clients where this might work, but we'll certainly try to do it," said Robert Franko, the president and chief executive of the $232 million-asset Beach Business Bank in Manhattan Beach, Calif.

However, "It typically does not work for borrowers who already have SBA loans," Franko said. "That's where we're seeing the most stress in terms of businesses. They are businesses who didn't qualify in the first place for a conventional loan."

The SBA has anticipated that lenders will make Arc loans mostly to their own customers, but officials still expect the program to be popular.

During a conference call briefing the media about the program, Eric Zarnikow, the SBA's associate administrator for capital access, said he expected the money for the loans to run out quickly, after "an initial ramp-up period for lenders to learn how to use the program."

Banks currently not participating in any SBA programs can sign up to become SBA lenders. Zarnikow said the process could take a week, an estimate Ballentine called "possible, but not probable."

"It's a Herculean task to do everything they're trying to do with this program, not even bringing in the auto program, and to sign up new lenders," Ballentine said. "By the time they do that, the money's going to be gone already."

The SBA is trying to moderate the flow of the $350 million allotted for the program. Zarnikow said that each lender participating in the program would be allowed to make 50 Arc loans per week, and that no single lender could exceed a total of 1,000 Arc loans. The agency said it expects a total of 10,000 loans to be made in the program before the money runs out.

Industry representatives said the program is already generating interest.

"Hotcakes will have nothing on this program," Ballentine said. "I've spoken to lenders saying not only are they getting calls, they're already getting people visiting their institutions asking to get this money."

Even if it is popular, some lenders may be cautious about using the Arc program under the current definition of a viable business. The SBA says the business must have been profitable in the past and must have cash-flow projections that prove its ability to eventually begin meeting all its obligations again. That is still too vague, said Scott Harvey, the executive vice president and SBA manager of the $69.4 million-asset Fortune Bank in Seattle.

"Given the SBA's predisposition to second-guess lenders, the ambiguous statement about what is viable is way too bad a situation here," he said.

Chris Reilly, the president of CIT Group Inc.'s small-business lending unit, said, "Conceptually, it's a good product." But, he said, "The issue is in the practical implementation. Eligibility is going to be the issue. What constitutes an eligible borrower?"

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